The conventional wisdom about the global dominance of the U.S. dollar is that it brings tremendous benefits to the American economy. U.S. firms can conduct their business internationally in their own currency, mitigating exchange-rate risks and transaction costs. Most of all, the U.S. government can finance its deficits at extremely low cost since dollar-denominated assets are in such demand. That’s why there is always so much consternation about the possibility that the dollar will lose its No.1 status as the financial state of the U.S. deteriorates.
But Michael Pettis, a finance professor at Peking University, offered just the opposite view in a recent essay in the Financial Times. Pettis argues that the U.S. would be better off if the dollar wasn’t the world’s premier reserve currency, and that the U.S. should actively work towards ending dollar dominance:
Conspiracy theory notwithstanding, claims that the reserve status of the dollar unfairly benefits the US are no longer true. On the contrary, it has become a burden, both forAmerica and the world.
Does Pettis’s argument make any sense?
His basic point is that the dominance of the dollar is forcing the U.S.to take on debt – the primary factor behind the economy’s recent disasters, and the primary concern about the health of the U.S. economy in future. That outcome is being caused by the trade and development policies of foreign countries, and especially those in Asia, which have encouraged large surpluses – a practice the very nature of the dollar-based monetary system enable them to pursue. Here’s Pettis:
Countries that seek to supercharge domestic growth by acquiring a larger share of global demand can do so by gaming the global system and actively stockpiling foreign currency, mainly in the form of, but not limited to, central bank reserves. In practice, dollar liquidity, limited Washington intervention, and the size and flexibility of US financial markets ensure that countries such as China stockpile dollars…But foreign acquisition of dollars automatically forces the US into running a corresponding current account deficit. Active trade intervention abroad, in other words, is accommodated by rising trade deficits in the US.
In other words, U.S. trading partners are abusing the dominant position of the dollar to drive their own growth, and the U.S. is paying the price. The persistent current account deficits force the U.S. into an awful choice – higher unemployment, or rising debt, and the U.S. has chosen debt:
This importing of US demand by other countries forces the US economy to respond in one of two ways. Either American unemployment must rise as demand is diverted abroad, or Americans must counteract the employment impact by increasing domestic consumption or investment…So in order to limit the impact on jobs, capital flows into the US must finance additional US consumption. Americans, in other words, must choose between higher unemployment and higher debt. In the past the Federal Reserve has chosen to encourage higher debt.
His conclusion is that what benefits the U .S. gets from the reserve status of the dollar are outweighed by the costs:
The large imbalances that this system has permitted now destabilise the world. If forced to give up the dollar, the world might reduce global trade somewhat, and it would probably spell the end of the Asian growth model. But it would also lower long-term costs for the US, and reduce dangerous global imbalances. The US should therefore take the lead in shifting to multi-currency reserves, in which the dollar is simply first among equals.
But what would the consequences of that be? William Shaw at the Carnegie Endowment for International Peace argues that the U.S. would be able to maintain many of the benefits of the global role of the dollar even it its dominant status declines:
As the United States pursues fiscally irresponsible policies that keep the debt high and other economies gain world GDP share, a multi-reserve-currency system is likely to emerge in the long run. This is not necessarily bad news—the United States can still retain most of its economic benefits, and transaction costs will stay low as long as the number of dominant currencies is limited.
This is all very interesting, but for me, Pettis’s argument raises two important questions. First, how does the U.S. actively work towards ending the global dominance of the U.S. dollar? Shaw details just how dominant the greenback is: more than 61% of official reserves are held in dollars; 85% of foreign exchange transactions are conducted in dollars; and 45% of all debt securities are dollar denominated. To reduce the dollar’s use in international trade and business, Washington would have to go out of its way to promote something else to take the dollar’s place. But what? There are no easy alternatives. Though the euro may eventually be a rival, it can’t be taken too seriously as long as the European debt crisis is still buzzing. The BRICS, in their summit this week, again promoted the IMF’s SDR as an alternative, stating in their final declaration that they “welcome the current discussion about the role of the SDR in the existing international monetary system.” But establishing the SDR as a serious contender would take a massive overhaul of the way business is conducted globally, since the private sector doesn’t use the SDR. So for now, the world is stuck with the dollar, and the U.S. is stuck with the world using the dollar.
And I’d be a bit more worried about the consequences to the U.S. economy of the dollar losing its No.1 position. Perhaps Pettis is correct, and the dominance of the dollar contributed to the build-up of American debt. But now that the U.S. has that debt, an end to dollar dominance could impose a very painful adjustment onto America. If the world demanded fewer dollars, and therefore fewer dollar assets, it would be harder to finance American consumption. That would force a faster deleveraging onto the American economy and American households. That may be just what the U.S. needs. But it may be extremely excruciating nonetheless.